Archive for the Category Level targeting


Gavyn Davies on the Fed meeting

Here’s Gavin Davies of the FT:

The startling recovery in risk assets in October – global equities rose by 11 per cent during the month – was triggered mainly by reduced pessimism on the eurozone’s debt crisis, but was probably also helped by easier monetary policy from several of the major central banks. As usual, the Federal Reserve has been in the vanguard of this action, and further measures are expected from the FOMC when it meets on  Tuesday and Wednesday.

There have been calls for major innovations, such as the introduction of a target for the level of nominal GDP, but the Fed has given little indication that it is ready for anything quite so drastic. Much more likely are some further modest steps to improve the communication of the Fed’s thinking on the future path of short rates, with the aim of keeping long rates as low as possible. And there might also be some more purchases of mortgage backed securities.

This certainly caught my attention, as there were three high profile endorsements of NGDP targeting recently; Romer, Krugman and Goldman-Sachs.  And there is only one person who was cited or linked to in all three statements.  I’m tempted to resurrect my connecting the dots post, but can’t really do so in good faith.  Davies is right; NGDP targeting is not going to be adopted at this meeting.  Indeed something that important ought to be widely debated first.  And that hasn’t yet occurred.  Still, I’d hope to see a mention that they are at least discussing the merits.

I do think Davies might be right about monetary stimulus chatter having some effect on equity prices recently, but I don’t see any firm evidence that would make that more than a conjecture.  In any case, any influence I have on that debate is an order of magnitude lower than the specific topic on NGDP targeting.

Davies continues:

Although the idea has merit, and may well be discussed by the FOMC in future, it is not likely to emerge from this week’s meetings.  Ben Bernanke has discussed many radical actions for monetary policy in the past, notably relating to Japan a decade ago, but I do not recall him ever giving much attention to a nominal GDP target.  He has consistently focused on the advantages of adopting a clear and consistent target for the rate of inflation (note, not the level of prices, but their rate of change, so past shortfalls would not need to be restored), and in a recent speech on 18 October he said the following:

“As a practical matter, the Federal Reserve’s  policy framework has many of the elements of flexible inflation targeting…The FOMC is committed to stabilising inflation over the medium term while retaining the flexibility to help offset cyclical fluctuations in economic activity and employment.”

A couple points.  Davies is right about Bernanke’s focus on inflation, but Bernanke actually has recommended the level targeting of prices.  Of course it was for Japan, not the US.  It’s too bad Bernanke has no interest in NGDP targeting, as it would achieve the objective laid out in that quotation far better than inflation targeting.  Indeed that Bernanke quotation is a textbook argument for NGDP targets.

He went on to argue that inflation targeting had proven its worth in stabilising inflation expectations in both directions in recent years, and he concluded as follows:

“My guess is that the current framework for monetary policy – with innovations, no doubt, to further improve the ability of central banks to communicate with the public – will remain the standard approach, as its benefits in terms of macroeconomic stabilisation have been demonstrated.”

If a 9% fall in NGDP below trend from mid-2008 to mid-2009, which led to massive and costly fiscal stimulus in the desperate hope it would prop up the very same aggregate demand that the Fed is supposed to be controlling is “benefits . . . demonstrated,” I’d hate to see a failed monetary policy.  And then there’s the sub-5% NGDP growth during the 27 month “recovery.”

Janet Yellen is particularly important here, since she is in charge of a Fed committee examining the matter. In her speech, she said:

“We have been discussing potential approaches for providing more information “” perhaps through the SEP “” regarding our longer-run objectives, the factors that influence our policy decisions, and our views on the likely evolution of monetary policy.”

The SEP is the Summary of Economic Projections, in which FOMC members give their outlooks for the main economic variables in the years ahead. It seems from Janet Yellen’s guidance that the Fed might decide to beef up this document so that it becomes more explicit about the nature of its long run inflation and unemployment objectives, and about the conditions underpinning its commitment to hold interest rates close to zero until mid 2013.

It is even possible that FOMC members might start to publish their entire expected path for short rates over future years, conditional on their economic forecasts. (Read my lips: no new rate hikes!”) The Chairman has explicitly pointed out that other central banks publish such projections of policy rates, which help influence market expectations of central bank policy.

The idea here would be to increase the confidence of the markets that short rates are intended to remain at zero for a very long time to come, which might in turn reduce long bond yields even further.  That would be useful in easing monetary policy slightly, but it cannot be expected to have very much effect when short rate expectations are already so low. More drastic options, like a target for the level of nominal GDP, will have to wait a while.

That doesn’t do much for me.  I’d say lower long term rates are more likely to be “evidence that monetary policy remains ineffective,” rather than “useful in easing monetary policy slightly.”  The Fed is still a long way from the point where it comes to grips with what actually needs to be done.  But at least they are searching for answers.

HT:  Richard W.

PS.  Joshua Lehner just sent me some interesting graphs comparing actual NGDP growth with Fed forecasts at different time horizons.  They obviously envision roughly 5% NGDP growth, and just as obviously aren’t doing level targeting.  Interestingly, he said the Fed stopped doing explicit NGDP forecasts in 2005, now it’s just RGDP and P.  That’s a bad sign.

Update:  Josh Lehner send me this post from his blog.

McCallum on NGDP targeting

This is from a recent paper on NGDP targeting by Bennett McCallum:

I find it plausible that movements in nominal spending growth would be more closely and reliably related to central bank policy actions””primarily open market sales and purchases””than would movements in inflation and output separately.  If so, then the central bank that targets nominal GDP would not have to rely upon its models of the way in which nominal and real variables are related, that is, its model of the “Phillips curve” relationship.  That is a significant advantage, because the Phillips curve relationship is the component of quantitative (econometric) macroeconomic models for which professional understanding and agreement is, by far, the weakest.  Thus, if the central bank can manage nominal spending growth in a manner that does not involve conceptually the Phillips curve, it can conduct policy without use of that elusive relationship.  By contrast, if it focuses on inflation and real GDP separately, or on inflation alone, it cannot possibly avoid its use.

The point of view expressed in the preceding discussion is somewhat reminiscent of Milton Friedman’s approach to price-level determination, in which he famously depicts the central bank as choosing the supply of money in nominal terms while the private sector is choosing the quantity of money demanded in real terms.  The interaction of these choices then determines the price level””see Friedman (1987, pp. 3-4).  In the present application, the central bank determines the amount of spending in nominal terms, with the private sector’s behavior determining how much of any change in spending will be in terms of (real) output changes and how much will be in (nominal) price level changes.

I like the analogy with nominal money supply and real money demand, which I’ve always seen as the core of monetary economics.  Indeed my biggest beef with Keynesians is that they don’t see Friedman’s example as the core of monetary economics.  I also like the pragmatism in McCallum’s approach.  We really don’t have good Phillips Curve models.  I think this is partly because our data is worse than many assume, and is less closely related to the theoretically appropriate concepts than many macroeconomists assume.  For instance, one reason why deflation is bad is because it’s less profitable to produce output when prices fall (if wages are sticky.)  In that context it’s interesting that official CPI figures show housing prices up 7.5% over the past 5 years, and the Case-Shiller index shows housing prices down 32% over the past 5 years.  Which provides a better estimate of the incentive to construct new houses?  Which is the inflation number used in actual economic studies by real world macroeconomists?  It’s also much easier to measure the nominal output of the health care industry, the consulting industry, or the PC industry, than to separately measure the prices and outputs of those two industries.   And even if we had accurate data, the Phillips Curve would be highly unstable due to things like the recent extension of unemployment insurance from 26 weeks to 99 weeks.  But the data problems make it even worse.

Here McCallum expresses skepticism about level targeting:

From the foregoing it can be seen that one issue that arises in discussions of nominal GDP targeting is whether the targets should be expressed in terms of “level” or “growth-rate” measures.  For an example of the distinction, suppose that the chosen rate of growth of nominal GDP is 4.5% per year.  Suppose that in some year, however, the central bank misses that target by a full percentage point on the high side, yielding 5.5% growth consisting of (for example) 3.0 percent inflation and 2.5% real growth.  Should the central bank strive for the usual 4.5% growth in nominal GDP again in the following year?  Or should it decrease its growth target to 4.0%, aiming thereby to be back at the original path for the nominal GDP level at the end of the next year?  In other words, should the nominal GDP targets be set in terms of growth rates or growing levels?  In the latter case, the disadvantage will be that policy that decreases nominal growth below its usual target value may be excessively restrictive, whereas the former case leaves open the possibility of cumulative misses in the same direction for a number of periods, i.e., it permits “base drift” away from the intended path.  My position on this issue has been that keeping with the target growth rates will, if they are on average equal to the correct value over time, be unlikely to permit much departure from the planned path and so should probably be preferred.  This is not at all a universal point of view, however, among nominal GDP supporters.

In this recent post I explained one advantage of level targeting; the fact that it leads market participants to assist monetary policymakers.  Perhaps I’ve been overly influenced by the 2008 period, when the advantages of level targeting seem relatively large.  I would also point to Michael Woodford’s work on liquidity traps.  Woodford argues that level targeting is especially important when a central bank hits the zero bound (as he is even more skeptical about QE than I am.)  McCallum may be right that when the central bank is doing its job, growth rate targeting is as good as or even better than level targeting.  By “doing its job,” I mean targeting the forecast.  But given the spotty track record of real world central banks, it seems to me that level targeting has a great advantage over growth rate targeting, the ability to prevent very large and costly errors.  It seems inconceivable to me that NGDP would have fallen 9% below trend between mid-2008 and mid-2009, if markets had known that the Fed was engaging in level targeting of NGDP and would soon return the economy to the trend line.

PS.  In my previous post I probably created the impression that I entirely agree with Romer’s post.  Those who view me as an inflationist may be surprised to learn that I actually think her recommendation is a bit too expansionary.  In 2009 I favored going back to the old (pre-2008) trend line.  I still think that policy would be better than the status quo.  But any dating of a trend line is arbitrary unless the Fed has set an explicit target.  As time goes by more and more debt and wage contracts have been set based on post-2008 expectations.  So at this late date it might be more prudent to only go part way back.

And in a sense this discussion is purely academic.  My fear is that the Fed will do too little, not too much.  My recent discussion of aiming for 6% or 7% growth for a couple years, and 5% thereafter, is actually far more conservative than the Romer proposal, but also represents the outer limits of what the Fed would be willing to do.  More likely they’d just shoot for 5%, with no catchup at all.  The same discussion occurred during the Great Depression, when some advocated going half way back to pre-Depression prices, and others advocated going all the way back.  They only went half way back, but even that would have been enough for a quick recovery if the NIRA hadn’t raised nominal wages by over 20% in the late summer of 1933.

PPS.  David Beckworth also comments on McCallum’s paper.

PPPS.  Lars Christensen also comments on McCallum.

The connection between level targeting and futures price targeting

I’ve talked a lot about the need for level targeting, i.e. setting a growth trajectory for NGDP and promising to make up for any near term overshoots or shortfalls.  And I’ve also talked a lot about the idea of targeting the price of NGDP futures contracts.  But I don’t recall talking about the connection between these two policies, which might shed some light on the importance of level targeting.

Policy lags are one of the difficulties that face monetary policymakers.  The Fed often doesn’t even know that the economy is in recession until several months after the downturn has begun (based on the retrospective dating of the cyclical peak by the NBER.)  It turns out that both level targeting and futures targeting help address this issue, in fairly similar ways.

Imagine a model where millions of people and businesses observe local demand shocks, and that data is aggregated 3 months later in the quarterly NGDP numbers.  It’s quite possible that the “market” would know things that no single individual would know—as the market will reflect aggregate optimism and pessimism, which is partly based on all those local demand shocks.

The advantage of NGDP futures targeting is obvious when there are policy lags.  The market will sense velocity changes before the Fed does, and offset them with adjustments in the base (or fed funds rate if you prefer to think in Keynesian terms.)  But how about level targeting, how is that like futures targeting?

Suppose that pessimism causes velocity to drop 2% before the Fed is able to notice and take corrective action.  Also suppose the Fed is doing plus 5% NGDP level targeting.  The markets will expect the Fed to return the economy to the trend line over the next 12 months.  This means they will now expect 7% NGDP growth; the normal 5%, plus another 2% to offset the near term shortfall.  This means they will expect easier money than if the Fed was doing growth rate targeting, and letting “bygones be bygones.”  More expansionary than if they settled for 5% growth after the 2% shortfall.

Now let’s assume that the markets notice the shortfall before the Fed does, and they expect the Fed to ease as soon as the shortfall is noticed.  That is, imagine a period like September 2008, when the TIPS market saw rapid disinflation but the Fed was still worried about high inflation.  In that case the markets will expect Fed easing before the Fed does.  Now recall than in modern new Keynesian economics the current level of aggregate demand doesn’t just depend on current short term rates, but also expected future short term rates.  I.e. it depends partly on longer term rates.  The anticipation of Fed easing will immediately reduce future expected short term rates, and will immediately reduce long term rates.  The market does the Fed’s work before the Fed even realizes there is a problem.

So with level targeting the market will be moving expected future interest rates around in such a way as to keep expected future NGDP (12 months out) right on target.  And here’s the best part of all.  Remember my initial assumption that NGDP temporarily fell below target, before the Fed corrected the problem?  It turns out that with level targeting the initial deviation from the target trajectory will be much smaller than if there was growth rate targeting, even if the Fed makes no immediate attempt to get the economy back on track.  Because the market will depress future expected rates, they will boost AD in the current period, even before the Fed noticed that there was a problem.

It’s not quite as good as NGDP futures targeting, but it comes so close that I’d guess it would deliver more than 90% of the potential efficiency gains from NGDP futures targeting, maybe 95%.  Given the current sorry state of monetary policy, that’s a lot of $100 bills lying on the ground waiting to be picked up.  Let’s hope the Fed notices them when it meets next week.

I demand perfection from the Fed

I don’t favor a 2% core inflation target, but if that were the target, then I’d want the Fed to set policy at a level expected to produce 2% core inflation.  Not 1.99% expected core inflation, and not 2.01% expected core inflation.  Precisely 2.0%.  Even better (and more consistent with the Fed’s dual mandate) would be a 5% target for expected NGDP growth.

Dallas Fed President Richard Fisher is one of the more colorful members of the FOMC.  Sort of the Rick Perry of Fed officials.  Here he indicates that he sets the bar for Fed policy at a level slightly below perfection:

Oct. 3 (Bloomberg) — Federal Reserve Bank of Dallas President Richard Fisher said the central bank has “plenty of ammunition” left if the economic situation turns “horrific,” while reiterating his view the Fed has provided enough stimulus.

One searches hard for analogies:

1.  Time to take a shower and cut my hair when my wife regards my appearance as horrific?

2.  Time to clean the bathroom when its smell is horrific?

3.  Time for the captain to adjust the steering wheel when the ship is off course to a “horrific” extent?

Maybe commenters have some better suggestions.

BTW;  What does “enough stimulus” mean? I thought Fisher believed the Fed had provided too much stimulus.  Wouldn’t the “horrific” situation be hyperinflation, calling for less ammunition?

HT:  Steve.

Memo to the Fed: We need a light at the end of the tunnel

The tunnel is low NGDP growth as far as the eye can see.  The evidence is low interest rates as far as the eye can see.  That looks like Japan.  The BOJ has failed to provide a light, and the results are clear.

What would be a light at the end of the tunnel?


There is zero justification for the Fed allowing a nominal recession to begin right now.  None.  If they do, history will judge them very harshly.

It may not happen, but the risk right now is unacceptably high.

Here’s Josh Hendrickson:

The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.

Here’s David Beckworth:

Still, I am not sure this new operation twist will pack much of a punch.  The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target.